All posts tagged: dividend vs growth funds

The Equity Mutual Fund comes in various forms. You can either invest your savings in a Small-Cap Fund or a Mid-Cap Fund. In addition to this, you have Large-Cap, Balanced Fund or Multi-Cap Fund to go for. You can opt also for an ELSS Fund if you are planning your personal Income Tax for the next Assessment Year.

Whatever be the category of an Equity Fund you choose to park your money in, this will either be in the nature of Growth Plan or Dividend Plan. In this post, we are going to discuss growth vs dividend mutual funds and which one is better for investors.

From the literal interpretation, it is not very unlikely that you might feel more inclined towards investing in the dividend plan at this point in time. Let us discuss why.

You might think that dividends from equity funds can be used for generating regular income. However, the fact is that regular dividend payouts are only possible if the fund generates profit regularly.

Moreover, for an equity fund to be a sustainable profit generating fund, the stock market is also required to be going upwards. If the market shows correction for a substantial period of time, it won’t take much time for the flow of regular dividend to get stopped.

Again, you might be an investor who thinks choosing dividend plan for booking regular profit without redeeming your units held. This might seem to be good as a strategy on the paper but, for its execution, proper planning is required.

Further, it could also be possible that you have just read the names of these two plans for the first time and completely unaware of the idea behind Growth and Dividend plan. You might not know what they actually mean and end up selecting something randomly just for the sake of investing in an Equity Fund.

Growth vs Dividend Mutual Funds

Now, let us understand how Growth Plan and Dividend Plan work in real life.

In the Growth option, the profits in the form of capital appreciation and dividend, made by your scheme are re-invested into the same fund. This will lead to the rise in the Net Assets value (NAV) of the scheme with time.

When the underlying portfolio of the fund makes profits, the NAV of its units rises. Similarly, you’re your fund runs at a notional loss, supposedly due to the market correction, the NAV of the same fund goes down.

In the case of Dividend Plan, the profits made by your fund are not reinvested back into the fund by the Fund Manager of the Asset Management Company (AMC). You get a share in the said profits in the form of dividends from time to time.

The amount of dividend you get and the frequency of getting the same are not predetermined. Dividends are only declared by the AMC when the scheme realizes profits in real.

In the Dividend option, the dividend is paid to you from the NAV of the units you hold, so paying dividend reduces your overall NAV.

Why Growth Plans?

In the Finance Act 2018 (Budget 2018), it is said that the Income Tax on Long-term Capital Gain @10.4% (including Health & Education Cess of 4%) will be charged on Equity and Equity oriented Mutual Funds. Now, Income Tax is only going to be applicable if Long-term Capital Gain crosses the threshold limit of Rs 1 lakh in the Financial Year 2018-19.

The said Budget has also introduced Dividend Distribution Tax (DDT) on Equity and Equity oriented Mutual Funds at an effective rate of 12.942%. Let us understand the break-up of the said rate of 12.942%.

Suppose you as an investor has got Rs 1000 as a dividend on your Equity Fund. Now, DDT is chargeable on the basis of “Grossing Up” concept. So, to pay Rs 1000 as a dividend by the AMC, the actual dividend comes to be Rs 1111.11{1000/ (1-10%)}. The rate of DDT is 10% so DDT comes to Rs 111.11.

The surcharge is calculated @12% on DDT which is calculated as Rs 13.33. Health & Education Cess @4% is to be charged on the computed Cess and Surcharge which gives the result of Rs 4.98.

So DDT comes to Rs 129.42 (Rs 111.11 + Rs 13.33 + Rs 4.98).

Although the DDT is chargeable in the hands of the Mutual Fund Company, due to the imposition of the former, you are getting Rs 129.42 less as a dividend. So, indirectly you are paying a hidden tax @12.42% on your dividend income. Whereas, in the case of long-term capital gain, you are only charged 10.4% by the Indian Government which is relatively lower.

Note: To know more about taxation on Mutual Funds for the Financial Year 2018-19, do check out this blog.

The above explanation substantiates that your Equity Mutual Fund investment with Growth Option, subject to Long-Term Capital Gain tax would be relatively more tax efficient than your investment in a Dividend Plan Equity Fund, where DDT is made applicable.

Furthermore, in accordance with the latest Budget, LTCG in an Equity Fund is only subject to Income Tax if the same exceeds Rs 1 Lakh in a Financial Year.

For example, if your Long-term Capital Gain in a growth plan investment is Rs 75000 for the Financial Year 2018-19, you don’t need to pay a tax on it. But, if the same becomes Rs 150000, then LTCG tax is chargeable on Rs 50000, i.e. the amount in excess of Rs 1lakh.

On the other hand, if you have invested in a dividend plan, the entire dividend you have received is subject to DDT. No exemption limit is applicable to an equity dividend option similar to a growth plan equity scheme. (If you want to know more about the Union Budget 2018-2019 please check out this file.)

The equity funds with growth plan are more appropriate for long-term wealth generation than dividend based equity funds. The amount of dividend you would receive in the latter option is not going to be a significant one.

You are most likely to spend that money in your day to day expenses and it is hardly going to be reinvested by you in the market.

But, if you have invested in a performing equity fund with growth option, the latter refrains from paying you any return in cash. So, the returns get reinvested in the same fund and get compounded year on year. This leads to the generation of substantial wealth in the long term.

If you like to know how to choose a Mutual Fund scheme for yourself, please check out this blog.

What if you have already invested?

If you have invested in a dividend plan and the duration has crossed a year, you are recommended to switch to the growth option within the Financial Year 2018-19. Here, switching means redeeming units of one fund and investing the proceeds in another scheme.

If the holding period of your investment is less than 1 year, the gains are to be treated as Short-term Capital Gains. In that case, you would be taxed @15.6% (including Cess). But, if your portfolio is bleeding (due to recent bearish market), you can even switch irrespective of the completion of 1 year of your investment. As discussed earlier, the Long-term Capital Gains, if any, would be taxed @10.4% (including Cess).

You can even choose to let it complete a year and gradually switch to growth plan so as to ensure that the Long-term Capital Gains do not go over the Rs 1 lakh mark.

Closing Thoughts: Growth vs Dividend Mutual Funds

In this post, we discussed that Budget 2018 has proposed Long-term Capital Gains Tax and Dividend Distribution Tax on Equity schemes.

We have also seen how growth option scores over a dividend plan as the former is more tax efficient and sound more suitable in generating long-term wealth. Therefore, from the entire discussion, it is very clear that the Growth plan is the obvious winner.